In Canoga Park, Calif., a couple laments that the husband’s hours were cut to part-time; while the wife holds down more than three jobs to make ends meet. During the New Hampshire GOP primaries, one televised interview showed a man on the verge of tears because his income has been cut to one-third.

When people cannot pay their bills and their mortgages, they sometimes get mortgage modifications, including a reduction of the loan balance. Or they appeal to their credit card companies and other lenders to reduce or waive their balances.

Whew! That’s over.

They sigh with relief after getting their debt load under control — until those notices come at tax time. The dreaded 1099-C, 1099-COD or 1099-A.

These notice tell IRS (and you) how much of your debt you no longer have to pay. All that unpaid debt is taxable income. Just when you thought you were in the clear, taxes rear their ugly heads.

One woman bragged that her brother had gotten a loan modification that reduced his loan balance by $150,000. Since this loan wasn’t subject to the protections of the Mortgage Debt Relief Act of 2007
, that whole $150,000 is taxable income. Just imagine his tax shock when he gets his tax return done this year.

Tax bankruptcy

Bankruptcy is another option. TaxMama has received a flood of questions about the topic in the last two months.

For help on this complex subject, we turned to attorney Susan A. Berson. Berson is a partner in The Banking & Tax Law Group in Kansas and author of Federal Tax Litigation (Law Journal Press 2001). Answers have been paraphrased and simplified. Remember, each person’s situation is unique. Different fact patterns will have different results.

Is there really such a thing as a tax bankruptcy?

No, there isn’t any specific procedure just for taxes. However, in the course of your Ch. 7 or Ch. 13 filing, certain taxes are among the debts that can be discharged.

What tax debts cannot be discharged in any bankruptcy?

Payroll taxes that were withheld from an employee’s paycheck cannot be discharged in bankruptcy. The IRS calls this the Trust Fund Penalty
. There are other strategies for dealing with this tax. But bankruptcy is not an option. Also, when the IRS or a tax agency has filed a lien prior to the bankruptcy filing, those would be considered priority taxes. Any creditor who has filed a lien gets paid from the assets of a bankruptcy estate, if there are any. However, Berson says that priority personal income taxes which are never dischargeable in Ch. 7 bankruptcy can be subject to discharge in Ch. 13 if it can be shown that the IRS failed to file a timely claim.

What tax debts can be discharged?

Personal and business income taxes are generally dischargeable – depending on your timing. When it comes to discharging taxes, the timing is the key.

Sometimes, it’s just impossible to hold off long enough get the taxes discharged, because you have an urgent need to file your bankruptcy right now. You face other debt pressures, like losing your home or your car. Perhaps an immediate bankruptcy can prevent these actions.

Talk about timing

OK, this is where it starts getting really complicated. There are exceptions or qualifications to each of these time frames. Let’s try to simplify this as much as possible.

There are three different time frames that relate to taxes.

Three years:
Taxes cannot be discharged within three years of the due date of a tax return. Let’s say you owe $10,000 for 2009. The 2009 tax return is due on April 15. 2010. That means you cannot discharge the 2009 tax debt until at least April 16, 2013.

Two years:
Taxes cannot be discharged within two years after a tax return has been filed. Suppose you owe $10,000 for a 2005 tax return that you filed on June 3, 2009. That’s more than three years after the due date. You can’t discharge those taxes until at least June 4, 2011, which is more than two years after the filing date.

240 days:
Taxes cannot be discharged within 240 days after they have been assessed. You filed your 2007 tax return on Jan. 5, 2009 and paid all the taxes due. It is now more than three years after it was due (by April 15, 2008). It is now also more than two years after you filed it (Jan. 6, 2011). But IRS started an audit in January of 2011. The IRS issued a final assessment of $10,000 in taxes on May 15, 2011. Jan. 11, 2012 is more than 240 days after the date of the assessment. So, you can now file bankruptcy to discharge those additional taxes.

When dealing with tax issues, there are things that tend to mess up the date count.

For instance, if you file for an offer in compromise, an Appeals hearing, or a Tax Court petition, you freeze the clock. So as long as those petitions or requests are unresolved or open, you need to add those days, plus certain additional days to the time frames above.

Another complication is arises for people who haven’t actually filed tax returns. Their tax debt resulted from tax returns the IRS or their state filed on their behalf. These are called SFRs (substitute for returns). SFRs are a down-and-dirty amount designed simply as a wake-up call. When you don’t file a tax return — and ignore the government’s reminders — the IRS and the states use the information they receive from W-2s, 1099s or average income from licensing statistics for various professions to generate an individual’s income. Then, using a “Single” filing status and no deductions, they compute your tax balance. Generally, your real tax balance is much lower.

The Bankruptcy Court doesn’t regard SFRs as filed tax returns or valid tax valuations. Before the clock can start on SFRs, you must either prepare a tax return or sign a statement that you accept IRS’s assessment as a valid tax. Which means, if you’re a non-filer, you typically have to wait at least two years after you file your tax return, before you can bankrupt your tax debt.

There are other issues that arise. If the court thinks your whole purpose for filing for bankruptcy protection is to defraud the government, they could deny your request to discharge the taxes.

Discharging taxes after the fact

f your tax would have been dischargeable in the original bankruptcy, the IRS will look at your case and consider discharging your tax debt. This little tidbit was revealed by an IRS official at one of TaxMama’s seminars about a decade ago. Since then, several tax pros have asked IRS to review their clients’ cases, and the IRS has canceled those tax debts.

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